Grand Tamasha

Viral Acharya on India’s Quest for Financial Stability

Episode Summary

This week, Milan sits down with Viral Acharya, former Deputy Governor at the Reserve Bank of India (RBI) to discuss India's financial stability.

Episode Notes

Thanks to the COVID-19 crisis, India’s economy is expected to shrink by at least 9 percent this fiscal year—a gut punch that comes on the heels of several years of continuously slowing growth. At the heart of India’s economic woes is a severe banking crisis that some have argued has sapped the vitality out of India’s investment cycle and consumed the energies of government economic firefighters. 


This week, Milan sits down with Viral Acharya, former Deputy Governor at the Reserve Bank of India (RBI) from 2017-2019, and author of the recent book, Quest for Restoring Financial Stability in India.


Milan and Viral discuss the health of India’s economy, the “silent crisis” afflicting India’s financial sector, the future of central bank independence in India, and the role that Indian economists based overseas can play back home. 

Episode Transcription

Milan  00:11

Welcome to Grand Tamasha, a co-production of the Carnegie Endowment for International Peace and the Hindustan Times. I'm your host, Milan Vaishnav. Thanks in part to the COVID-19 crisis, India's economy is expected to shrink by at least 9% this fiscal year, a gut punch that comes on the heels of several years of continuously slowing growth. At the heart of India's economic woes is a severe banking crisis that some have argued has sapped the vitality out of India's investment cycle and consumed the energies of government economic firefighters. My guest on the show today was, until recently, one of those called up to put out the fire. Viral Acharya is the C.V. Starr Professor of Economics at the New York University Stern School of Business. From January 2017 to July 2019, Viral was a deputy governor at the Reserve Bank of India, the RBI. He's the author of a brand-new book, a compilation of many of his writings during his government stint, titled Quest for Restoring Financial Stability in India. It's a pleasure to welcome him to the show for the very first time. Very good to talk to you.


Viral  01:09

Thank you, Milan, my pleasure, and look forward to the interaction.


Milan  01:12

So, let me begin by taking us back to the year 2017. You know, I can almost picture in my head - one day, you were sitting in your comfortable office at the NYU Stern School of Business, a tenured professor at one of the world's most prestigious and best-ranked business schools, and the next day, you were taking a flight from Newark Airport to go to India to take up a new position as the deputy governor of the Reserve Bank. How did this position, this life change come about? And why did you decide to return home and take the plunge?


Viral  01:45

Governor Rajan finished his term at the Reserve Bank of India, and the then-Deputy Governor, Dr. Patel, became the Governor, and so the Deputy Governor position in charge of monetary policy, research, and markets became open as a result around July or August. I had a sense that this position would be announced for people to apply. Given my background, which was a lot in banking - and I had been doing a lot of advisory roles at various central banks and systemic risk boards that were getting set up after the global financial crisis - I thought I could be a suitable candidate, at least worth a consideration for the Government of India. So, I had a video interview in early December, I believe, December 2016. And, of course, when you go for these things, you don't know what the competition is, so you don't know who else is in the mix, but I knew that at least I would have a shot. And, you know, it turned out they did give me a chance, and there I was. I decided to do it for two reasons. One, at a personal level, for someone who is doing research in central banking, financial crisis, systemic risk, macro implications of finance, a central bank is really the position to be in - you can apply your research, you can bring some rigorous data, conceptual frameworks to it, and simultaneously, you can learn a lot by being on the job. But, second and foremost, as I explained in the book, I felt that India needed to clean its banking sector at that point of time, and I thought, given all the work I had done in my research, as well as with the central banks, I could be the person who could help this effort in a significant way. I wanted to give back to India, in some ways. I always feel India is always inside me, regardless of where I am, and I thought this could be a good opportunity, a good time to make that significant contribution.


Milan  04:20

Viral, you mentioned that one of the reasons you were motivated to go back is that the banking sector needed to clean up and you felt that you could contribute. You argue in the book that a "silent crisis" has been playing out in the Indian banking sector ever since, really, the boom and bust of credit-driven fiscal stimulus following the global financial crisis of 2008. I'm wondering if you could explain to our listeners who are not all economists by any stretch why this crisis has been a silent one, in your view?


Viral  04:51

Absolutely. So, I think it's not specific to India. It's specific also to China and several other countries or regions - emerging markets, especially, where a big part of the banking sector - and, in many cases, even other financial firms, such as insurance companies, non-bank finance - is owned by the government. Now, when you have banks that are owned by the government, what happens is that even if they make huge losses - say, even twice the quantum of losses that was seen at the time of global financial crisis - depositors in these banks still have the confidence that the government is standing behind their liabilities. Now, as a result of that, you could have losses mounting, banks not generating profits, banks not lending to the real economy, and yet nothing significant happens. Depositors are continuing to go and put their money into the banks. And, paradoxically, what I have documented in my research is that at the time of the global financial crisis, even some of the weaker public sector banks actually received further inflows of deposits because the savers actually wanted the safety of being in a government-owned bank, a state-owned bank. Now, why is it nevertheless a crisis? I think it is a crisis because we should not think about banking problems only through the mirror of depositors running for their deposits. Ultimately, why do we care about the health of banks? We care about the health of banks because banking is a part of the lifeblood through which the real economy prospers. Individuals, small- and medium-sized businesses, even large corporations are reliant on an efficient flow of bank credit so that they can undertake the productive investments that they might have access to. Now, when you have a bank that is making losses and is not getting recapitalized because, actually, the depositors don't care which is the bank they are investing in - because it is state-owned, for example - nevertheless, the real outcomes might not be great. In fact, what has happened in India, what has happened in several other countries, is that undercapitalized state-owned banks do two things. One, they do what is called zombie lending, which is that they keep evergreening the loans of their defaulted borrowers. There are many terms used for this. A famous one is "extend and pretend": you extend the maturity of a defaulted loan and pretend as though everything is okay. Usually, the regulators turn a blind eye because they are themselves getting compromised and providing regulatory forbearance. But what zombie lending does is that it throws good money of the savers after the bad, and with a state-owned, state-backed bank. Ultimately, this is going to come back to the taxpayers at one point or the other in the form of losses. The second thing that these undercapitalized state-owned banks do is called lazy lending: they simply buy government bonds because they don't have any capital, so they don't want to take any new risks. They just punt on government bonds, hoping that interest rates will decline and at some point, they can make gains. Now, regardless - on the one hand, zombie lending makes the credit to the healthy parts of the economy very expensive. And what does lazy lending do? It generates so little return on banks' balance sheet that over a period of time, banks can't even serve the depositors’ interests very well. And so what gradually has been happening in India is that the state-owned banks are now losing even the share of their deposits in the market, but it's happening at a very glacial pace for it to be called a crisis. Nevertheless, as far as the real engine of the economy is concerned, which is private credit, growth, private investments, they are stagnating because a very big part of the banking system, the public sector banks are simply not in a position to lend well to the economy. That's why I call these a silent crisis. They can go on for many years, even a decade, even longer than a decade, and what you lose is the growth potential of the economy while all this is playing out.


Milan  09:31

So, I feel like we need to step back for a second and maybe provide some additional context for our listeners. I want to refer to something that you wrote in the opening chapter of your book, where you list a number of motivating questions that you say kept you up at night thinking about how to resolve them. One of them, in particular, struck me as a genuine puzzle with no easy answers, and I just want to read out that question. It goes, "Why are efforts at restoring financial stability seen as contradictory to pursuing growth even though all evidence points to financial stability being a necessary condition for long-term growth?" A simple way of paraphrasing that would be, can there be no gain without pain?


Viral  10:15

Yes, this is a question that has actually puzzled me even in the context of developed economies, where banks are not necessarily state-owned and are very often private. And there are several shades to resolving this puzzle. First and foremost, I would say, governments tend to be myopic, very often, in their policymaking. Especially when growth slows down, you have an electoral cycle that's demanding that the government have demonstrated a significant track record of being able to keep growth high, and they have a tendency to want to pump-prime the economy. Now, you can't generate stable growth in a short period of time without undertaking a significant analysis or diagnosis of what has gone wrong, figuring out the right structural reforms to undertake, and it may take a couple of years before you are able to put in place those reforms and get the economy back on track. Now, what's a convenient way out for the government's is to - if it's state owned banks - to directly give them quotas or mission targets to lend to specific parts of the economy, especially the vote banks that the government's may be trying to swing in their favor. If it is private banks, you can get the central bank to be compromised in terms of its lending standards or supervision so that banks are allowed to extend credit such as the subprime credit that we saw in the United States. So, this is one key factor: that governments tend to be myopic in how they want to give a pretense of growth, especially when electoral compulsions arise. The second key point is that, as an individual that's receiving this credit, or even as an analyst on the street that's trying to analyze how the growth is actually beginning to start showing signs of revival when this credit growth picks up - unless you have the perspective that short term debt-based stimulus, if it is not done with good underwriting quality, is going to lead to a bust of the leveraged cycle down the road that is very difficult to mop it up - it's costly, it takes long, and it can be very painful for the economy when this leverage bust is getting cleaned up - unless you have that clear perspective, everyone gets focused on the short term numbers. So, the myopia of the government in its policymaking choices carries over to the recipients of the credit and, to an extent, even the analysts who are very often focused on covering quarterly growth numbers or the annual growth numbers and so on. Now, that brings me to the third point. Of course, we have seen this play out over and over and over again in different parts of the world, and yet why is it that regulators and central bankers who are pushing for financial stability, researchers who keep calling out that leverage booms go bust if they are not contained in time - why do they not get the attention they deserve? And I think, to sum it up, I would use the title of Carmen Reinhart and Ken Rogoff's book: this time is different. Every situation is a bit different. There's new technology, there's a new government, there are new growth challenges, the global situation is different. It's easy for everyone to revolve around this narrative that growth is weak, we need to kick start it, we have found the way to kick start it, credit is booming, the economy is taking off - and, you know, the voices that are actually leaning against the wind of this mistake are very often few, and usually they get paid attention to only once the boom has actually gone into a bust cycle. I think a part of what researchers such as me, central bankers such as Dr. Reddy, who successfully leaned against the end of the housing cycle in 2006 and 2007 in India, the Bank for International Settlements, which has become a big proponent of actually not risking financial stability for short-term growth - what all of these efforts are trying to do is to build greater awareness of the fact that credit-based stimulus has a back-ended risk that it may go past, that you need to have extremely well-capitalized banking systems, you need to do stress tests. And I think I would end with that thought, which is that stress tests are a great way of focusing the attention of people on risks that have not yet materialized. The analogy I always give is that of building a bridge. The engineers have figured it out: when they build a bridge, the safety standards that they subject the bridge to are not normal time pains. The question they ask is, can the bridge withstand hurricane or cyclonic winds so that it will not crash, it will not fall apart, it will not become weak for the vehicles that are going from one shore to the other? In my view, we need to elevate the standards of banking regulation to similar safety standards, where we say that the financial bridges that are being built from the savers to the borrowers in the economy need to be able to withstand cyclonic or hurricane-style winds of macroeconomic risks.


Milan  16:03

So, let me just push you a little bit further on this point. You emphasize government myopia. Let's go back to 2013, 2014, when the outlines of India's twin balance sheet crisis were already apparent - that is, the over-indebtedness experienced by large infrastructure companies and the high and rising share of nonperforming assets on the books of primarily public sector banks. You note in the book that, in many ways - and you've just said it again - the problems experienced in Japan, in Europe, have been rather similar to what India has gone through. In all cases, you go through a period of severe banking stress, and the authorities fail to adequately recapitalize their struggling banking sectors. In the Indian case, in particular, was it just the same kind of myopia that prevented authorities from taking decisive action? Because I remember talking with people, even those who were advising the Prime Minister at the time on the campaign trail, and their hair was on fire saying, "Unless you solve this twin balance sheet issue, you will not be able to remove this vise-like grip on the economy, and there's no way, no matter how much you spend, the investment cycle will be rejuvenated."


Viral  17:23

I think there are three factors that are at work here. Typically, at the beginning of the term, governments are sometimes willing to actually undertake the effort of cleaning up the banking sector's balance sheets when they have gone bad. Part of it is it's convenient politically, as well, in a narrative to say, "Banks were left in a very bad shape by the previous government, we are going to clean it up." And then, hopefully - as I said, the process of cleanup is long and painful, it takes minimum two to three years to rebuild the balance sheets back to a healthy shape - and so, hopefully, if they are in good shape by the time the next electoral cycle comes about, you can claim victory both for the cleanup as well as for the healthy credit growth that may come about when banks are restored to reasonable shape. So, early on in the electoral cycle, they are willing to come along. And, as I say in the previous chapter of my book, indeed, for ten months after I joined - ten to twelve months - it looked like we were on track. There was government commitment to reform the banks, put in capital, but only in the healthier banks, not so much in the weaker banks - put the weaker banks under prompt corrective action so that they stop bleeding and became smaller over a period of time - and resolve the underlying defaulted borrowers through the government's own fast track resolution mechanism of insolvency and bankruptcy code. But what happened - and I think this is where the government myopia comes into play - is that because of a few structural reforms that didn't work out as planned - maybe they were ill-conceived in the first place - growth started slowing down, and the government started resorting more and more to short-term policies as the election horizon kept getting closer and closer. And, as I explained earlier, what's the most convenient short-term policy? Throw credit at the problem, get the banking sector to lend to the economy, so you can pump-prime the growth of the economy to look good. And so, as I explained, everything that we were trying to do in ten, twelve months to restore the foundations of financial stability in India took a U-turn. Progress stalled, capital was thrown at weaker banks rather than stronger banks, banks were taken out of prompt corrective action by diluting the standards, and there was a stay on resolution of some of the legacy loans, as you said, from the fiscal stimulus of '09 to '11, '12. So, I think the short-term compulsions, in the end, especially combined with weakness of growth, are, in my view, the most fundamental bottleneck. But I would add two more bottlenecks here. The second important bottleneck is bureaucracy. In my view, especially in India, for bureaucracy, public sector banks are a form of control: they are a form of turf, they give them a mechanism to try and re-engineer short term growth when other policies that they have tried to do have failed. And you can actually see that when growth has slowed, because it's a combination of the failure of policies in various ministries, they all come together in a nice, synchronized orchestra of essentially saying, "It's the central bank’s fault. The interest rates have been kept very high, they are trying to clean up the banks when the economy should be on a revival path, they need to cut rates, they need to relax the standards." And the central bank becomes like this common outside enemy, so to speak, for everyone who's inside the government, because now they can deflect attention from their failures, their mediocrity of choices, and focus attention collectively on getting the central bank to take the blame, get compromised, what I call "fiscal dominance" - get it to cut rates, get it to pump liquidity, get it to relax the credit standards. So, I think bureaucracy in India has also played a key role in resisting the banking sector reforms in the end. And third - which is less appreciated, subtle, but I think an equally important bottleneck - is that, if you if you take an objective view of 40 to 50 years of public sector banking in India, who has it served? It was done under the guise of development and financial inclusion for the longest time. That is not what these banks were doing. In fact, India's credit to GDP ratio is still barely between 50 to 60% in the aggregate, so clearly, this 50-year experiment has not played out as it was championed and marketed to start with. But, in my view, the constituency that it has served the most is the middle class in India that gets sort of cushy, not the best pay, but sort of high job security positions at these public sector banks, the public sector insurance companies, power finance companies, other kinds of state-owned enterprises - and the labor unions are a very important part of the constituency that resists any change. Because we are reaching, in India, a situation where the fiscal costs of continuing to bail out public sector banks and the huge losses that they keep undertaking are perhaps becoming untenable. They are now competing with, you know, COVID-related relief, repair, and other efforts that are required. Now, that means you have to restructure this system. The decisions that were taken 40, 50 years back to nationalize a big part of the banking system, they have to be gradually unwound. The governance of these banks may have to be taken out of government's hands and be brought back to the markets. But, when the markets take over these banks, eventually, they will want to change the incentive structures. Jobs will not be as secure without performance. And this is a churn that the labor unions will also resist, and therefore they want the cushy government ownership, just the way that depositors want the safety of the public sector banks. The labor wants the safety of government ownership and weak governance because then their jobs remain cushy. So, the government, the bureaucracy, and the labor: they are all three big impediments, in my view, to turning around the public sector banking. But, if I had to pick one out of these, I would say the primacy of the problem here is with the myopia of the government, because ultimately it is going to require political will to turn this sector around. And if electoral compulsions keep coming in the way of getting political consensus, then this is just a ticking time bomb as far as the fiscal costs are concerned.


Milan  24:47

You have been a votary for strong, independent central banking. In the book, you argue that central banks must be granted de jure, not just de facto, independence, and this is an important signal of their credibility both internally as well as to the outside world. Of course, there's a large literature in economics about the role of central bank independence. The impression many observers get - those who are not insiders but people who are viewing this system from the outside - is that India is heading in the wrong direction when it comes to this issue of central bank independence. Do you think that there's something to this commonly held sentiment?


Viral  25:28

I would say certainly there is. And what I try to explain in the book, and Dr. Reddy's masterful foreword to my book also provides a fairly compelling historical perspective, is that essentially what happens over stretches of time is that, when growth is strong, government balance sheets become more manageable - you know, they are raising decent tax revenues, household savings are high if the growth rate has been high, so it's easy for the government to borrow in the markets at reasonable costs - and when that situation arises, they don't need to actually start looking to dominate the central bank to help the funding of the government borrowing programs either through cutting of interest rates, buying off government debt, or, as I said, at times, pump-priming of the economy by relaxing bank lending standards and capital standards. Now, why do these things fluctuate over a period of time? I think it's very important to understand this because it's not just that economics is an outcome of the policies that the central bank follows - in my view, the economics also determines how much the central bank is going to be under pressure from the governments in order to compromise its policies. So, take the '70s and '80s, for example. India was mostly a centralized, nationalized economy. We had a huge presence of the state in real economy as well as in banking. And - Dr. Reddy puts it in a very witty manner - the government, the central bank, and the public sector banks were a Hindu undivided family in which no one kept anyone's accounts. Now, in that economy, it didn't matter for a while because there was no private sector. Who were you crowding out? No one, really, because there was no private sector to talk of. But, of course, the imbalances were building up, and the growth rate that could be attained over that period was barely three, three and a half percent. And, ultimately, we had the balance of payments crisis nevertheless: now, in the early '90s, and in 1998 to 2003, India liberalized the economy, the government divested its stakes from public sector enterprises, the growth was high, global growth was very high, and the situation was very conducive to allow the central bank to become more and more independent and operationally autonomous. In fact, the central bank got out of direct purchases of government treasury bills or meeting the government short term expenditures for the first time, and a series of reforms were put in place, both on fiscal management as well as on central bank's operational autonomy, to actually move the economy from a system that was primarily geared for the government and the state-owned banks to becoming a more decentralized, liberalized, market-based economy. But then came the global financial crisis. Growth slowed down, global growth created headwinds for the domestic economy's growth, as well, and gradually, over a period of time, the government balances started slipping because growth was not easy to come by. They started resorting to the fiscal stimulus of, you know, doing directed or behest lending to various parts of the economy. It didn't work out well, as we discussed - that leverage boom and bust. And, as a result of these weakening government balances, weak growth - and, over this period of time, actually, the household savings rate has also been declining, which is a somewhat underappreciated important macroeconomic fact over the last decade, that household savings have been declining in India, especially over the last four or five years as a percentage of the GDP - all of this meant that the conditions that were conducive to allow the central bank to remain autonomous, for the economy to become more market oriented, now started disappearing. And what we are seeing, therefore, is a re-emergence of the fiscal dominance of the central bank. There are so many pressure points - I give six concrete examples, all the way from the desire for central bank's balance sheet to interventions in government bond markets to disclosure of bank loan losses to regulatory forbearances, where you simply say that banks can continue to lend even if they are not in great shape - and all of these factors have taken over. And I would just make a last point here, Milan, which is that, therefore, why is the independence of the central bank important in the letter of the law? Because over periods of time conditions that will create incentives to fiscally dominate the central bank keep changing. Now, if the letter of the law is very weak to start with - the RBI Act is one of the weakest acts in the world in terms of granting operational autonomy to the central bank - if the letter of the law is weak, it becomes very easy for the underlying factors to lead to fiscal dominance of the central bank. And so, therefore, I think there is a room to create institutions that will lead to more rule-based decision making so that the central bank cannot be pressurized to engage in discretion and dilute its regulatory standard.


Milan  31:17

I suppose this is a natural segue to ask you about the speech that probably got the most attention by the press during your time at the RBI. It's a speech where you spoke about this theme of central bank independence. In it, you have the following to say: "As many parts of the world today await greater government respect for central bank independence, central bankers will remain undeterred. Governments that do not respect a central bank's independence will sooner or later incur the wrath of financial markets, ignite economic fire, and come to rue the day they undermined an important regulatory institution." So, pretty powerful language. In response to this, there have been many people in government, columnists and others who have argued that this statement of yours in the Indian context is overly hyperbolic or sensational insofar as we have seen two recent RBI governors exit in what you might call less than normal or ideal circumstances, Raghuram Rajan and Urjit Patel, and the sky has not fallen as a result. How would you respond to those who respond with this criticism?


Viral  32:35

My response is the following: that these two governors who have left, they actually left behind a very important institution for the country, and that institution was the inflation targeting framework that has been put in place. Of course, the government ultimately put that into legislation, but these were the architects of the inflation targeting framework. Now, what this inflation targeting framework has done, in spite of the gradually slipping and now sharply slipping fiscal deficits of the government, it has kept inflation expectations of the markets relatively at bay for a while. In the last two to three quarters, inflation has risen very sharply, partly on the back of food inflation, but even core inflation has risen very significantly, and inflation expectations have started rising. Nevertheless, for a stretch of time, because the central bank remains committed to inflation targeting even though the underlying fiscal imbalances were picking up, I think the macroeconomic situation has remained stable and not devolved to the situation of examples I gave in my A.D. Shroff Memorial Lecture, such as Argentina or Turkey, where such credibility is actually not there because the central banks have not tied themselves to the mast, saying, "Even when government debts are rising and the pressures are there, we will retain our focus on inflation." I think the key question going forward, not just in India, but also in other central banks, is going to be, as the government deficits and debts are mounting as we come out of COVID, will the central banks be able to retain their commitments to focus on price stability and not get distracted by the borrowing needs of the government? In emerging markets such as India, inflation is high even at present. In developed countries, inflation is short of the target. But, increasingly, both investors and researchers are attaching a higher probability to inflation picking up as we recover from COVID, given all the printing of money and the competition of governments and private sector for credit growth that might take place. And I was very careful in the code to say, "sooner or later." I think we have to wait out. Because, usually, for emerging markets, domestic imbalances are managed through repression of policies - the financial sector gets repressed by government bonds, central banks, depending upon their inflation targeting mandates and how strong they are, may get compromised to support government bond markets, etc. So, emerging markets tend to use domestic policies to repress the economy for a while. Crisis doesn't take place, but, of course, you have the growth and imbalances building up. Usually, the problems get triggered through an external shock, such as an increase in the interest rates by the Federal Reserve or normalization of its balance sheet by the Federal Reserve. It could be an event such as a Brexit or a sovereign default somewhere else, which creates risk aversion towards emerging markets, and then the external investors vote with their feet. For economies that don't have the right initial conditions at that point of time, I still stand by my code: I think that economies which weaken their central bank's commitment to long-term policies - not just on inflation but also on bank regulation, also on protecting depositor interest - those whose central banks get weakened will probably get a whiplash of the markets. Then you get a combination of domestic imbalances and external sector shocks.


Milan  36:30

You know, I should say we're recording this in mid-October 2020 - but I'm curious about your views on how the present economic crisis will shape the future of relations between the government and the banks. There is already a moratorium on loan repayments in place. Many people are openly arguing that regulators must continue to go easy on borrowers. Of course, these arguments have been made before, and we've seen the protracted resolution that followed, but are we in a special period of time because of COVID? And does the widespread economic havoc that this pandemic has brought forward, is that a reasonable enough excuse to take the foot off the gas pedal as it were?


Viral  37:17

I'm somewhat of a stickler on this. My experience has been no matter how large the shock, it always pays off to run a well-capitalized and healthy banking system. At the time of the global financial crisis, it was the largest shock at that point of time of our lifetimes, and what you observed since then is that countries such as the United States, which fixed their banks quickly after the banking failures that took place, have recovered far better in terms of their growth and resilience of the banking system than countries, like several parts of Europe, where the banking systems were not actually recapitalized in a decisive manner. What is the lesson therein for recovery during and after COVID? It's, one, that while clearly it is super important to provide relief and debt restructuring relief to the real economy, if the costs are borne by the banking system, we need a strategy for them to be able to absorb these losses. If the losses that they bear are not provided for quickly, then what's going to happen is that in twelve or eighteen months, when recovery out of COVID is picking up steam, private credit growth is seeing a revival, undercapitalized banks may remain focused on legacy problems, they will again do zombie lending and lazy lending rather than lending to healthier borrowers of the economy. And rather than being an amplifier of post-COVID recovery impulses, they might actually act as impediments to the recovery because they won't be channeling capital efficiently when we come out of the COVID shock. So, in my view, the benign equity market conditions that we have right now, should be used over a six-month, twelve-month time, but in a decisive manner, to ensure that the health of the banking and the rest of the financial sector is in great shape when we are coming out of the COVID shock and growth impulses are picking up again. The important thing to keep in mind is that, right now, demand is very weak, so it's alright for banks not to be that well-capitalized. They are buying government bonds in a very significant way, all the debts are getting restructured, and so the losses are not getting marked up, and so the stress is not manifesting. I would actually call it a form of the silent crisis that is playing out, where the regulators the world over have agreed that we will not make the landing very hard for the banks and the financial sector. But if the economic losses are there, they will have to be recognized at some point, and the preparation for that must start now. Otherwise, the legacy of these losses will leave scars for the real economy down the line.


Milan  40:26

So, as we come to the end of our conversation, I want to ask you about your views on another hot button issue, which is the privatization of public sector banks. I recall meeting a ruling party member of parliament several years ago who, when asked about the prospect of such privatization, responded that a direct push to privatized public sector banks would likely never happen, and the reason is that, instead, the government would be inclined to pursue a strategy of slowly merging consolidated public sector banks while gradually opening up more and more space, prying that open for the private sector. So, this is a kind of a strategy of, you know, death by a thousand cuts rather than a kind of direct assault. Is this strategy good enough, in your view, to revive the things that ail the Indian banking system?


Viral  41:19

Absolutely not. I fully agree that this is what the government and the bureaucrats want: they want to do the minimal so that you don't fall off the precipice because it helps to have control over these banks to come prime the economy when the electoral compulsions arise. See, mergers don't change the economic scale of the public sector banking's imprint in the Indian economy. There are some advantages of merging them - you have to start fewer positions, maybe intercreditor agreements are easier to coordinate if there are fewer players in the system - but mergers by themselves don't really solve the fundamental problem of governance and quality of these banks. Now, there's an important difference between a public sector bank and the public sector enterprise that we have to keep in mind when thinking about this. And what is the difference? If I'm getting a bad car from a public sector enterprise, I'm not going to buy it. If it's an inefficient company that's producing substandard cars that are not fit for the Indian Roads anymore, I'm not going to buy that junker. In contrast, as we have been discussing, the sovereign guarantee makes the deposits of the public sector banks attractive on the safety dimension compared to some of the other banks' deposits, such as private banks. Now, as a result of this, this "backdoor" or "creeping" liberalization of the financial sector happens really, really, really slowly compared to what would happen, say, in a telecom sector, for example, when entry was allowed and private players gradually just took up the market share very, very quickly. Now, this is not good enough, because you can't have an entire five- or six-year period where 50%-plus of the deposits are with banks that aren't in a capacity to lend well to the real economy. That's going to mean low growth, low private investment, low consumption, and so on. The last point here, Milan, is that I think this idea that there will never be a factor that leads to reform is, I think, overdone in India, because reform can happen through internal consensus or reform can happen through financial constraints. When did Southeast Asian countries liberalize their financial sector? This was when they had a Southeast Asian crisis in '97, '98. The costs of bailing out the economy were so large that they had to shed majority stakes and even in some cases have a complete reprioritization of their financial sector. I think we are reaching a point in India where the fiscal costs of continuing to bail out public sector banks are becoming so large that they are competing now with alternative and important expenditures such as relief and repair for the COVID-affected parts of the economy. In my view, we should not wait for a crisis to make this happen, because then you are under duress, you end up relinquishing the stakes at very low prices, you get the wrong kind of buyers into the financial system. It's better to lay out a blueprint right now for an 18-month or a 24-month period over which the government will improve governance, shed stakes below majority, and eventually reprioritize some of these banks. If not, you know, financial constraints may actually force these decisions to restructure the banking system.


Milan  45:04

So, Viral, there are so many other things I want to ask you about - I sent a message last night, several messages, to economist friends, asking for suggestions, and I think you're going to have to write a whole second book because they had many more questions that they wanted me to ask. But let me end by asking you to perhaps reflect on a kind of more philosophical note, which is the role of Indian economists based overseas. I think it's fair to say that economists like yourself - there are, of course, many others - have often found themselves in the crosshairs in recent times, and I'm wondering, how would you address those who are skeptical that Indians, NRIs residing abroad, have a real role and contribution to make in policymaking back home?


Viral  45:51

I think the right way to see this is that it's not really a clash about, you know, those who are trained domestically versus those who are trained abroad or based abroad. I think it's a clash of ideologies. I think it's a clash of wanting the economy to be run in a more centralized and nationalized manner, with the bureaucracy and the government playing a bigger and bigger role, versus making the economy more private, liberalized, decentralized, and [driven] through market forces. My sense is, by and large, the foreign-trained or foreign-based economists have wanted to strike a better balance between the role of the government, the central bank, the markets, and the banking system, they have wanted the government to reduce its imprint in the banking system, and in several other non-strategic sectors where the government still remains very big in India. If you want, it's like the debate between Keynes and Hayek. Everyone looks up to Keynesian policies when there is a downturn, but we pay too little attention to the Austrian economists who warned us that if you don't keep these stimulus policies contained, the role of the government will keep getting bigger and bigger, and then there will be growth-damaging influence that a large government will start putting on the economy. I think it's the clash of these ideologies. In my view, the discussions in India, especially the narrative, is regressing in taking the economy more towards the '70s- and '80s-style model of a centralized, nationalized version of the economy rather than the '90s and early 2000s narrative where we were growing very fast, and that was on the back of substantial reforms that happened to liberalize the economy. I think it's a good fight. We'll see how it plays out. We need all the sound bites to make a critical voice for striking a better balance in the Indian economy, in my view.


Milan  48:03

My guest on the show today is Viral Acharya. He is the C.V. Starr Professor of Economics at the New York University Stern School of Business. For a two-year period, from January 2017 to July 2019, Viral was a deputy governor of the Reserve Bank of India. He's the author of a new book entitled Quest for Restoring Financial Stability in India. It's been published by Sage Virtual. The book is a picture of clarity about the banking and financial crisis in India. I think this podcast is a picture of clarity in terms of how you've been able to unpack what can be a very technical and difficult-to-grasp set of topics for our audience, so thank you so much for taking the time and coming on the show.


Viral  48:44

Thank you, Milan, for the opportunity.